What is key-person life insurance?

The key person policy is not necessarily a ‘type of policy’, but a way to use life insurance to offset a significant business risk.

Who is a Key Employee?

A key employee may or many not be an owner; however, key employees:

• Are generally highly paid and responsible for management decisions
• Exert a significant impact on sales and enjoy a special rapport with customers and creditors

Why is Key Employee Life Insurance Needed?

A business suffers from a key employee’s death in many possible ways:

• A loss of management skill and experience
• Disruption in sales or production
• Missed business opportunities
• Credit difficulties (such as an inability to make payments or a creditor’s reluctance to extend credit)
• Increased expenses associated with hiring and training a replacement

The Process of Placing a Policy

The business notifies the employee that it will purchase a specified amount of life insurance on the employee’s life, and the key person consents in writing. The business applies for and is the owner and beneficiary of the life insurance policy. If the insured employee dies, the business receives the policy proceeds. Premiums are not deductible, and death proceeds are usually not subject to federal income tax.

Because the business holds all incidents of ownership in the policy, the death proceeds are not included in the insured employee’s estate for federal estate tax purposes unless the employee is a sole or controlling shareholder. In this situation, a corporation’s incidents of ownership are attributed to the shareholder-employee.

• One method for determining the amount of insurance is the “contribution to earnings” method. Under this method, the business estimates the key person’s contribution to yearly profits and multiplies it by the estimated number of years the employee would have worked. The result can be appropriately discounted to establish a basis for how much life insurance to purchase currently.
• Another method is the “cost to replace experience” method. Here, the business takes the key person’s compensation, subtracts the amount of salary attributable to routine duties, and then multiplies that number by the years required to bring a replacement up to the key employee’s level of experience. Add to this the expenses associated with recruiting and hiring a new employee to determine the appropriate amount of key employee insurance.

Tax Implications

• Premiums are not tax deductible, as the business is the owner and beneficiary of the policy.
• Proceeds paid to the business are typically excluded from federal income tax when the notice and consent requirements have been met.
• If the proceeds are paid in installments, the interest portion of each installment is taxable to the business.
• Properly structured, the insurance has no tax impact on the key employee unless the employee is also an owner. In this case, when the key employee dies, the value of the deceased owner’s stock and business interests may increase in the estate when the business receives the life insurance proceeds, potentially resulting in greater estate tax.

Other Advantages

• If the key person doesn’t die while employed, the business can use the cash value of the policy to meet other needs.
• The policy demonstrates financial stability to creditors, or the cash value can be used as collateral for a loan.
• For key employees who are owners, the policy could help fund a buy-out of the deceased person’s business interest.
• If the policy isn’t needed to protect the business, the cash value can be used to provide deferred compensation or retirement income for the key employee.

Common Use Cases

Key-man, Key-woman or Key-person life insurance is a great solution for protecting a business or organization from the economic impact of losing a key-person in management, sales, or ownership of the business. Examples of common uses include:

• If there are two business partners and one dies, the remaining, living-business owner can use the proceeds to purchase the partner’s share of the business.
• The proceeds can be used to pay for the recruiting, hiring, and training of a replacement for the deceased person.
• If the company cannot continue operations because of the death, it can use the funds to pay off debts, distribute money to investors, provide severance benefits to employees, and close the business down in an orderly manner.